~ Investment Strategy

Morning Note: market’s horizons, Iran, Eurozone breakup, gold

The market often seems to have a short horizon. For example, according to the FT this morning, European markets have rallied in anticipation of the European leaders’ meeting tomorrow, even though it was a well-known fact when the market fell through its present level that EU leaders do meet with each other.

One way that you could attempt to explain this market behaviour would be to see it as the result of shifting assessments of probability. The tail risk of a Greek euro exit has come into the market; it is likely that EU leaders will attempt to do something about it; but it is not certain that they will do so. As EU leaders do in fact attempt to take action, the chance of their taking no action disappears and the extreme outcome becomes less likely. However, there are two problems with this. First, the chance of inaction has to be quite large for this effect to explain the moves in the market — and that does not seem to accord with European leaders’ actions to date. Second, no action has yet been taken — it is precisely the market’s focus on the likelihood of action that has apparently caused the market to rally in advance.

I note that the market did not actually rise very much this morning, and has now fallen back, so it is probably overstating the case to say that a significant rally has occurred on account of the imminence of the EU meeting. It is my observation that such events can have effects at the margin — creating small moves comparable to the market’s usual range — but that highly predictable future events do not cause large multi-week swings in the markets.

Why should they even have effects at the margin? Because the marginal seller is the one who affects the price, and the marginal seller, who already had positions he was considering exiting, is the one who is most inclined to react to short-term news flow. If he comes into the office and the headlines are bleak, he is more likely to edge over his mental threshold for selling. If he comes in and they are a bit better, he is more likely to hold on. That ought to account for the apparent shortness of the market’s time horizon.

Iranian Nuclear Talks

The second round of six-party talks with Iran about its nuclear programme are imminent. There is upward risk to oil prices from any breakdown — the first, initial, meeting appeared to go well (although nothing substantive was agreed) and that seems to have taken some risk premium out of the oil price already. According to Bloomberg, the West wants Iran to stop enriching uranium to 19.75%, because such enriched uranium can be further enriched to make material for a bomb. It can also be used to make medical isotopes, however, and part of any agreement might be for the West to process Iran’s enriched uranium into fuel rods for its Tehran Research Reactor, which makes these isotopes. Again according to Bloomberg, Iran has recently signalled that it is ready to consider such an arrangement. We should remember that this is only the second meeting, at the first at which substantive issues will be addressed, and there is scope for disappointment. That said, the West seems disinclined to loosen sanctions on Iran without tangible progress in the talks, and the sanctions have already bitten in a meaningful way. Officially, US financial sanctions against countries buying oil from Iran come into effect on 28 June; the EU oil embargo begins on 1 July.

Eurozone Breakup a Good Idea?

Gideon Rachman, writing in the FT, writes that Eurozone breakup would be the best option for Europe, if only governments could sit down and make a rational assessment of who should stay in and who should leave. First, the idea that an intergovernmental discussion could work like this demonstrates an almost insane naivety. Second, the EU has already attempted such a rational discussion — about who should be allowed to join!

Gold

Gold has recently broken its relationship with real interest rates, moving decisively outside the scatter plot for the previous two years. Anecdotal reports suggest a lack of retail interest, although I suspect that this is an effect, rather than a cause, of gold’s recent range-bound trading. I am inclined to think that risk aversion on arising from the Greek situation is responsible for gold’s decline and that the metal will, sooner or later, rebound. But the FT reports, interestingly, that gold in Indian rupees is actually close to its highs. I wondered whether the strength of USD (and weakness of currencies like INR) could account for the recent breakdown of gold’s relationship with real rates. A brief bit of modelling on Bloomberg suggests that, in the short run, it can. For the past year, the relationship between gold and the US dollar index has been stronger than the relationship between gold and real interest rates. Perhaps the best way to think about this is to see real interest rates as setting a broad level for gold, and the gyrations of USD as affecting its short-term moves.

UK public sector net borrowing continued its downward meander in April (ex the effect of the government’s assumption of the Royal Mail pension scheme, which has distorted the figures — the assets are included in the net debt calculation but the liabilities are not).